After Years of Regulatory Uncertainty, ICOs Are Fleeing the United StatesBy Jack Filiba
Initial Coin Offerings (ICOs), for better or worse, changed the way businesses and startups approach fundraising. While fundraising has historically been a process which excludes entire swathes of the public, ICOs allow just about anyone to “invest” in a project by purchasing its native digital asset (although that “investment” typically doesn’t confer any equity ownership).
However, ICOs don’t just raise funds, they also raise a litany of concerns for regulators. Nothing quite like ICOs existed in the world before blockchain technology. As a result, the sudden billion-dollar ICO boom left regulatory authorities like the U.S. Securities and Exchange Commission (SEC) playing catch-up.
As the crypto industry grows, ICOs have been targeted by regulators all over the world, leading to a sharp decline in this kind of fundraising. Other variations of this crypto fundraising model, such as Initial Exchange Offerings (IEOs) have become a lifeline, though they are not immune from regulatory consequence either.
Now, with a recent string of actions and threatening statements targeted at ICOs, the once-lagging SEC seems to be on the precipice of putting its foot down. For instance, in June 2019, the Commission announced that it is suing the Canadian company Kik Interactive over an alleged unregistered token sale it launched almost two years prior.
“Following SEC statements, the number of ICOs has declined sharply since mid-2018”
“The number of ICOs has declined sharply since mid-2018, after SEC officials made a series of statements suggesting that ‘all ICOs are securities’ and that the SEC would pursue enforcement actions against future ICOs,” Diego Zuluaga, a policy analyst at the Cato Institute's Center for Monetary and Financial Alternatives, told LongHash.
“While there have been only a few ICO-related enforcement actions alleging unregistered securities offerings, the regulatory uncertainty persists.”
While the U.S. Securities and Exchange Commission’s suit against Kik Interactive is a relatively rare instance of enforcement action against ICOs, it is not unprecedented.
Crypto proponents have long been wary of the SEC’s increasing role in this space. In 2017, the Commission drew scrutiny for retroactively debating if Ethereum’s original token sale was a securities offering. Proponents feared that the debate could be a warning sign that the SEC’s days of watching from the sidelines were over. The Commission ultimately concluded that the Ethereum token sale was not a securities offering, but that most digital tokens are securities.
Securities offerings are a long-existing fundraising method that falls directly under the purview of the SEC. Today, ICOs do not have to register with the SEC prior to their launch. However, if the Commission believes an ICO is actually operating as a securities offering, the project’s creators may be violating Section 5 of the Securities Act of 1933, which states:
“All offers and sales of securities must be registered with the SEC or qualify for some exemption from the registration requirements[.]”
For many projects in the crypto space, a lack of clear guidance surrounding securities offerings is a serious risk. While a project may not believe its coin offering functions as a security, the SEC could disagree and take legal action.
In fact, according to Robert W. Greene, ICOs are targeting other markets in an attempt to escape the strict purview of U.S. regulators. Greene is a Fellow at the Singapore University of Social Sciences, and previously served on the leadership committee of the Chamber of Digital Commerce’s Token Alliance.
“The SEC's regulatory posture has certainly driven projects seeking to conduct an open digital token offering to locate outside of the United States,” he said. “According to research that I will be publishing next month, U.S.-registered projects accounted for over 10 percent of open digital token offering dollar-volume in 2017 versus just 2 percent in Q3/Q4 2018.”
Why coin offerings are shunning U.S. participants
A high-profile ICO launched in early 2019 by BitTorrent, a popular peer-to-peer file sharing application, reportedly made $7.1 million dollars in just 15 minutes. To purchase tokens in the ICO, users had to be identified as per Know-Your-Customer (KYC) requirements, and BitTorrent explicitly barred U.S. residents from participating.
ICOs turning away from the U.S. market is an ongoing trend. As the SEC’s actions towards the landscape have appeared increasingly strict, many modern coin offerings have prohibited residents of the United States from getting involved.
“Digital token projects seeking to conduct a digital token offering to a wide-range of institutional and retail participants increasingly restrict U.S. persons from participating because of high uncertainty surrounding whether the SEC will view a particular open digital token offering as an illegal unregistered public securities offering,” explained Greene. “This can result in costly regulatory actions or class-action lawsuits, even if the token project is based outside of the U.S. and that distribution is legal elsewhere.”
To help genuine projects navigate regulation, the SEC previously vowed to release a framework that would make it easier for market participants to accurately assess whether or not their ICO launch was subject to securities laws.
Greene pointed out that when this framework was released in April 2019, it did little to provide clarity. He quoted SEC Commissioner Hester Peirce’s criticism of the framework, which said its release may actually have an adverse effect and "contribute to the feeling that navigating the securities laws in this area is perilous business."
Commissioner Peirce’s remarks seem to reflect industry sentiment. As the Wall Street Journal reported, ICOs brought in $118 million USD in Q1 of 2019. During the same time period in 2018, they raised $6.9 billion USD.
Further, research conducted by BitMEX found that the ICO market was down around 97% in Q1 2019. Even the push towards Initial Exchange Offerings (IEOs) may not be the cure-all some believe it to be.
“In this relatively challenging climate to raise funds, some projects have changed the ‘C’ in ICO to an ‘E,’ perhaps in an attempt to assist with raising capital,” BitMEX Research wrote. “At least for now, to some extent, this appears to be working, with almost $40m having been raised so far this year. However, we remain sceptical about the prospects for long term investors.”
The SEC’s concerns are appropriate, but eliminating ICOs is not
Few in the industry would advocate that the SEC completely turn a blind eye towards ICOs, especially since many fail to deliver on their promises to investors. However, sweeping regulatory crackdowns may unintentionally prevent the emergence of genuine projects.
“[The SEC doesn’t] understand the nuance between token projects and wants to avoid issuers using a loophole to avoid securities registration,” explained Zuluaga, of the CATO Institute — an American public policy research organization. “This concern is legitimate and important, but the SEC should make an effort to provide an off-ramp for crypto projects that, in good faith, wish to issue something that is not a security.”
Without room to breathe, projects would rather leave the United States than try to compete in a hostile regulatory landscape. Zuluaga’s sentiments were largely echoed by Greene, who said that:
“Given the SEC's current regulatory posture, projects wishing to conduct a digital token distribution that allows members of the general public to participate are understandably — and unfortunately — quite wary of permitting U.S. persons to participate in token sales.”
Greene explained that blockchain projects still have methods to raise capital in the United States. Unfortunately, these methods may be antithetical to the democratic ideals of the crypto industry, as Security Token Offerings (STOs) and Regulation D safe-harbor sales are often limited to institutional buyers.
Greene’s research underscored Singapore’s role as an emerging market for ICOs. In addition, the island nation of Malta continues to express an interest in becoming a harbor for blockchain and crypto crowdfunding innovation.
While some projects may be able to leave the U.S. in favor of friendlier regulatory environments, the SEC’s stance might mean others will have to give up on their ICO plans altogether.
As Zuluaga explained, “not all token projects necessarily have the ability to move to an alternative jurisdiction and navigate a foreign regulatory environment.”